Brexit Scenario Planning

About a month ago, I looked at the likelihood, and expected FX impact, of the three main Brexit scenarios, as summarized below:

Following a tumultuous week for Brexit, which began with the EU’s brutal elimination of Theresa May’s Chequers proposal, and ended with Jeremy Corbyn’s apparent volte-face on the so-called ‘people’s vote’, it is worth returning to the subject of Brexit planning, this time to look at the likely first order outcomes of the currency process (i.e. what will happen next, rather than likely end-game). For the record, in terms of the ultimate Brexit end-game, I still feel that the probabilities and odds stated above are broadly accurate, despite all the short-term chaos that has occurred over the past few days.

Scenario I – The Snap Election

Perhaps the most notable consequence of the apparent death of Chequers is the rising possibility of new elections. This week-end’s UK papers were full of rumours that May is being advised that her best (only?) way out of the current mess is to go back to the electorate to secure a stronger mandate (likely running as a Brexiteer). The betting odds reflect about a 45% chance of an election being called either later this year, or in 2019. Currently, the most likely outcome of the next election is a minority government (40%), with very roughly even odds of Labour and the Conservatives having the most seats. There are also about even odds of either a Labour or a Conservative majority government (30% each). Overall, the calling of a new election may cause a very short-term spike in GBP (as the odds of ‘no Brexit’ would rise), but I expect that the increased political uncertainty created would soon reverse this and send GBP lower.

Scenario II – Canada-type Deal

Persuading Theresa May to reject Chequers in favour of a more conventional free trade deal, based on the EU’s deal with Canada, seems to be gaining support around the Cabinet table. We would consider this approach to be a ‘Hard Brexit’ outcome, which would push GBP lower, albeit the downside for GBP in this scenario would likely be smaller and of shorter duration. The challenge for this strategy would be to secure parliamentary backing (notably among pro-EU tory MPs), which is why the probability of this outcome, in my view, is about 25% .

Scenario III – EEA (the ‘Norway Option’)

This is the favoured solution of many Tory Remainers (as well as some pragmatic Brexit supporters). However, it faces vociferous opposition from most Brexiteers, including Boris Johnson and the European Research Group, and would likely struggle to get through Parliament, unless substantial backing from Labour could be secured (high unlikely). This scenario is therefore less likely than a Canada deal, but still possible, and I estimate about a 10% probability of this outcome occurring. An EEA solution would be a boost for GBP, likely pushing it into the high 1.30’s.

Scenario IV – Blind Brexit (35%). GBP Higher

If Theresa May decides to proceed on her current path (essentially viewing the Salzburg ambush as a negotiating tactic by the EU and continuing to horse trade on Chequers), then the only way through (other than ‘no deal’) is the so-called ‘Blind Brexit’. This would involve essentially agreeing on a fudge to get the UK into the transition phase, without any real clarity on the endgame. The relatively high probability that I assign to this outcome is because: It averts ‘no deal’ (for now) which many in the UK and the EU are terrified of; It could avert the need for an election (which the Tories are terrified of, meaning it would be easier to get the agreement through parliament); and It does not require signing up to a so-called ‘Hard Brexit; – it would leave everything still to play for, so to speak meaning pro-Remain Tories could be cajoled into getting on aboard, especially if the alternative was ‘No Deal’.

Scenario V – No Deal (30%). GBP Lower.

Even though most officials in the UK and the in the EU would prefer to avoid this outcome, there is a relatively high probability a ‘no deal’ Brexit, if for no other reason than this is the default option. Those who claim that ‘there is no majority’ for a ‘no deal’ Brexit miss the point; that is, to avoid ‘no deal’ some positive action is required. Theresa May has categorically ruled out a second referendum, so the only way to avoid a ‘no deal’ Brexit may be to call a general election. Even looking at this from the perspective of the most ardent pro-Remain Tory, this is a hard option to swallow, as it could result in an extreme left-wing government coming to power. A ‘No Deal’ Brexit would be painful for the pound, likely leading to a depreciation of at least 10%.

Scenario VI – Second Referendum (20%). GBP Lower

The only plausible way for a second referendum to occur, in my view, is for a general election to be called, and then for Labour to win it. Based on current betting odds (45% for an election, and 50% for Labour to win), this would put the chances of a second referendum at just over 20% (for the record, betting markets currently imply a 25% – 30% chance of a second referendum). Because, based on this assumption, a second referendum would only occur with a Labour government, it is far from clear that a second referendum would provide a boost to GBP, irrespective of which side were to ultimately win. In any case, in the short term, the pound would almost certainly weaken.

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